Coworking Exposure May Raise Risk Profile of U.S. Office REITs

Coworking providers have established a sustainable position in key global office markets, due to a fundamental and generational shift in office demand trends, and are benefiting the US office REIT sector, according to Fitch Ratings. WeWork, one of the largest coworking space chains in the world, has rapidly grown to encompass a mid-single-digit percentage of key global office markets but this rapid growth could raise tenant credit risk and artificially boost rents in select office markets.

Shared office space providers combine functionality with high design and hospitality elements to aggregate and diversify risk associated with smaller, less established tenants that have traditionally been unable or unwilling to lease office space. The high level of investment by coworking companies in space buildouts can also benefit asset values. However, the shared office space business model entails an asset/liability duration mismatch that favors flexible customer commitments over long-term customer contracts that help offset the high capital intensity of office assets.

Public comments by US equity REITs and other commercial real estate-related companies regarding the coworking segment during recent earnings calls reveal mixed views regarding the upside and downside of coworking exposure. Some companies, including Boston Properties (BBB+/Stable) and SL Green Realty (BBB/Stable), view coworking as an important net absorber of space. Others such as Empire State Realty Trust believe coworking disrupts the relationships between tenants, landlords and brokers with outsized risk from weak equity-dependent business models.

Top tenants of US office REITs have traditionally been investment-grade industrial and financial corporates, enabling them to effectively manage rental income risk. However, growing exposure to speculative-grade coworking space chains, such as WeWork (BB-/Stable), may increase tenant credit risk. This will inevitably make evaluating REIT tenant concentration and credit and retention risk an even more important factor in credit analysis.

Long-term leases are a key positive office sector attribute that helps balance high capex and leasing costs. However, WeWork caters to smaller, less established tech and new media startups, which we expect in aggregate will underperform established peers during a downturn. Notwithstanding limited structural lease security, we believe WeWork's ability to curtail growth investments in a downturn to improve its financial flexibility and reputational risk will sustain the company's willingness to satisfy its long-term lease obligations.

We view the traditional landlord/lessee model where a REIT landlord leases space to coworking providers under a long-term agreement, providing lease incentives based on prevailing market conditions and practices, as more credit friendly. A fee-based management model whereby the landlord bears the capital investment and cash flow risk in exchange for greater potential upside are less credit friendly.

Fitch's CMBS group takes a cautious approach to analyzing properties where WeWork is a key tenant. This includes ensuring rents are at, or below, market levels and that the space is fungible to facilitate backfilling the space with new tenants, if necessary. If WeWork is the property's single tenant, a dark value analysis that assumes an immediate lease default and certain assumptions for downtime between leases, carrying costs, re-tenanting/releasing costs, developer's profit, etc. is performed to ensure the dark value covers the high implied investment-grade proceeds for the loan.

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